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Nations and Firms in the Global Economy

This accessible introduction to the world economy and to the theory and practice of

globalization argues that key topics in international economics cannot be understood

without a knowledge of international business, and vice versa. It reviews and combines

insights from both literatures and applies them to real-world issues, clearly explaining

the main concepts of international economics and business in a uniquely integrated

approach. Written in a lively and accessible style, this innovative textbook covers all the

main issues, including international trade, capital mobility, comparative advantage, for-

eign direct investments, multinational behaviour, financial crises and economic growth.

It includes carefully selected international examples and case studies, and special interest

boxes which clearly explain more challenging economic concepts. The companion web-

site includes additional case studies, exercises and answers to exercises, data, illustrations

and links to other useful websites.

Steven Brakman is Professor of International Economics at the University of Groningen.

Harry Garretsen is Professor of International Economics at the Utrecht School of

Economics, Utrecht University.

Charles van Marrewijk is Professor of Economics at Erasmus University Rotterdam.

Arjen van Witteloostuijn is Professor of International Economics and Business at the

University of Groningen and Professor of Strategy at the University of Durham.

iii

This book is a remarkable achievement. It covers all the pressing international economic issues

of our day in an accessible yet thorough manner. The authors adroitly combine illustrative

data and essential theory to explain the hows and whys of trade and trade liberalisation, the

delocation of firms and multinational activity, capital flows, currency and financial crises,

and the role of international organisations such as the IMF and WTO. It is appropriate for

students without an economics specialisation both at the undergraduate and non-specialists

graduate level, e.g. MBA and Masters of Public Administration. The facts and real-world feel

of the book make it interesting as a supplement for specialist students as well.

Richard Baldwin, Professor of International Economics,

Graduate Institute of International Studies, Geneva

International trade and international business have hitherto existed in two separate worlds

a world of nations and a world of firms in academic teaching and even in research. This

book gives us a welcome integration of the two at the level of teaching. Students who use it

will develop a unified vision that will benefit them in their future careers, whether in business,

government, international institutions, or academic research.

Avinash K. Dixit, Department of Economics, Princeton University

This is a fascinating book with a practical approach to international economics that enhances

our understanding of the globalisation process.

Hans-Werner Sinn, President of the Ifo Institute for Economic Research, Munich

This book offers a valuable integration of the economics and business aspects of globalization.

The integrated approach makes the book a unique and valuable resource for students of

international economics and business studies.

Prof. Dr. Joseph Francois, Tinbergen Institute, Rotterdam, and CEPR, London

Understanding the enormous changes taking place in the world economy requires the per-

spectives of many different disciplines, of which international economics and international

business are two of the most relevant. Yet until now these two fields have interacted very

little. This new text does a superb job of combining the insights of these two complementary

academic fields. The authors present a lucid overview of theories of international economics,

with an emphasis on recent contributions such as imperfect competition, multinational cor-

porations, agglomeration and financial crises. In addition they present a wealth of relevant

and insightful case-studies from the international business literature which helps bridge the

gap between theory and reality. Students in a range of courses will benefit from this integra-

tion of different approaches, and researchers who want an overview of recent work in fields

outside their own will learn a lot too.

J. Peter Neary, Department of Economics, University College Dublin

Nations and Firms in theGlobal EconomyAn Introduction to International Economics and Business

Steven Brakman

Harry Garretsen

Charles van Marrewijk

Arjen van Witteloostuijn

cambridge university pressCambridge, New York, Melbourne, Madrid, Cape Town, Singapore, So Paulo

Cambridge University PressThe Edinburgh Building, Cambridge cb2 2ru, UK

First published in print format

isbn-13 978-0-521-83298-4

isbn-13 978-0-521-54057-5

isbn-13 978-0-511-16099-8

Steven Brakman, Harry Garretsen, Charles van Marrewijk, Arjen van Witteloostuijn 2006

2006

Information on this title: www.cambridge.org/9780521832984

This publication is in copyright. Subject to statutory exception and to the provision ofrelevant collective licensing agreements, no reproduction of any part may take placewithout the written permission of Cambridge University Press.

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Published in the United States of America by Cambridge University Press, New York

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hardback

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Contents

List of figures page xii

List of tables xv

List of boxes xviii

Preface xxi

Glossary xxv

Suggested course structure xxviii

Part I Introduction

1 The global economy 1

1.1 Introduction 1

1.2 A sense of time: the universe and population 4

1.3 Income levels: GNP and GDP 10

1.4 What is the global economy? 18

1.5 Globalization and income 21

1.6 Globalization and international trade 26

1.7 Analyzing the global economy 30

1.8 Conclusions 39

2 International accounting practices 40

2.1 Exciting accounting? 40

2.2 Macro-level accounting: a countrys balance of payments 41

2.3 Micro-level accounting: a firms annual report 47

2.4 The importance of distinguishing between micro and macro 55

2.5 Accounting principles as a platform 56

Part II Firms, trade and location

3 Trade and comparative advantage 63

3.1 Introduction 63

3.2 Comparative advantage: David Ricardos fundamental insight 64

3.3 Comparative advantage versus competitiveness 69

3.4 Comparative advantage: the neo-classical answer 72

3.5 The closed economy 73

viii Contents

3.6 Open economy international trade: the HeckscherOhlin result 78

3.7 Factor endowments and competitiveness 80

3.8 Fragmentation 83

3.9 Fragmentation: an evaluation 91

3.10 Conclusions 93

Appendix: HeckscherOhlin algebra 94

4 Trade and competitive advantage 96

4.1 Trade and imperfect competition 96

4.2 Understanding intra-industry trade: monopoly power 100

4.3 The trading equilibrium 103

4.4 Strategic interaction between firms: the AirbusBoeing example 107

4.5 Monopolistic competition 110

4.6 Trade with monopolistic competition 113

4.7 Empirical support for intra-industry trade 116

4.8 Conclusions 119

Appendix 4A: strategic interaction: reaction curves 120

Appendix 4B: derivation of the Helpman equation 124

5 Firms, location and agglomeration 125

5.1 Introduction 125

5.2 Distance in economics 126

5.3 Geographical economics 130

5.4 The geographical economics approach: an example 133

5.5 Geographical economics: a further discussion 136

5.6 Multinational behaviour 139

5.7 The boundary of the firm: outsourcing 146

5.8 Conclusions 151

Appendix: a more general model of multinational behaviour 152

Part III Capital, currency and crises

6 International capital mobility 161

6.1 Introduction 161

6.2 Measuring international capital mobility 162

6.3 Issues about capital mobility 167

6.4 Determinants, benefits and costs of capital mobility 176

6.5 Summing up and looking ahead 180

6.6 Policy autonomy 182

6.7 Conclusions 188

ix Contents

7 Gains from capital market integration 190

7.1 Introduction 190

7.2 International allocation of savings and investments 191

7.3 The degree of international capital market integration and a puzzle 196

7.4 Does capital flow in the wrong direction? 198

7.5 Capital flows and risk diversification 205

7.6 Firm investment and asymmetric information 210

8 Investors, exchange rates and currency crises 217

8.1 Introduction 217

8.2 What is a currency crisis? 218

8.3 Characteristics of currency crises 222

8.4 First generation models 226

8.5 Second generation models 229

8.6 Coordination 233

8.7 Efficiency 235

8.8 Frequency and measurement 237

8.9 Looking ahead 240

9 Financial crises, firms and the open economy 241

9.1 Introduction and terminology 241

9.2 An asymmetric information view of financial crises 242

9.3 Disruptions and asymmetric information 243

9.4 A financial crisis framework 245

9.5 Financial crises in an open economy 247

9.6 Wake-up call and perverse savings 252

9.7 Evidence about twin crises 256

9.8 Bad fundamentals or malicious investors? 259

9.9 Synthesis and conclusions: the vicious circle 261

Part IV Policy, dynamics and organization

10 Trade and capital restrictions 267

10.1 Introduction 267

10.2 Welfare effects of trade restrictions: a tariff on imports 268

10.3 World welfare effects of trade restrictions 272

10.4 More on protectionism 273

10.5 Trade agreements 277

10.6 Evaluation of the demand for and supply of trade protection 283

10.7 Capital restrictions: the trade-off between efficiency and stability 285

x Contents

10.8 The welfare effects of a tax on capital inflows 287

10.9 The pricing of risk and the role of policy 289

10.10 Two examples of capital restrictions: preventing crises 293

10.11 Capital restrictions as a cure for crises 296

10.12 Changing the international financial system? 298

10.13 Rounding up the restrictions 300

11 Globalization and economic growth 304

11.1 Introduction 304

11.2 Catching-up 305

11.3 Production, capital and investment 307

11.4 Empirical implications 312

11.5 Technology, knowledge, innovation and TFP growth 318

11.6 Open economies, TFP and economic growth 320

11.7 An historic example: Japan 325

11.8 A recent example: China 332

11.9 Conclusions 335

12 Nations and organizations 339

12.1 Convergence or divergence? 339

12.2 Game theory: basics and terminology 347

12.3 An experiment 350

12.4 HRM and cultural diversity 352

12.5 Corporate governance and institutional diversity 359

12.6 Recent Americanization? 365

12.7 Conclusions 369

Appendix: the Bertrand duopoly experiment 370

Part V Conclusions

13 Globalization: is it really happening? 375

13.1 Introduction 375

13.2 Income inequality over time 377

13.3 Does globalization make the rich richer and the poor poorer? 378

13.4 Low-skilled labour, trade and within-country income inequality 381

13.5 Low-skilled labour and the irrelevance of trade 383

13.6 Outsourcing and income inequality 388

13.7 Developing countries and the globalization bonus 390

13.8 Conclusions 395

xi Contents

14 Towards an international economics and business? 397

14.1 Glocalization 397

14.2 More than macro or micro alone: multi-level interaction 402

Bibliography 406

Author index 426

Subject index 430

Figures

1.1 Big Bang and beyond page 5

1.2 Development of world population over the last 2,500 years 6

1.3 Developments in world population, 20002050 7

1.4 Gross domestic product (GDP) and gross national product (GNP) 12

1.5 Correction of GDP per capita for purchasing power, 2000 16

1.6 Development of world per capita income over the last 2,000 years 22

1.7 Advantages and disadvantages of logarithmic graphs 23

1.8 Leaders and laggards in GDP per capita: a widening perspective 25

1.9 Carrying capacity of European merchant fleets, 14701780 27

1.10 Two waves of globalization 29

1.11 Trade and market integration 31

1.12 London external bond spread, 18701940 35

1.13 Foreign capital stocks, assets/world GDP, 18602000 35

1.14 Relative migration flows, Western Europe and Western Offshoots,

18701998 37

1.15 Traditional and globalized fragmented production processes 38

2.1 A countrys balance of payments 42

2.2 Current account balance, selected countries, 19702000 46

3.1 Wages per hour and GDP per hour, 19972001, selected countries 68

3.2 An isoquant 75

3.3 Cost minimization 76

3.4 Lerner diagram, goods prices and factor prices 77

3.5 The impact of international trade 79

3.6 Fragmentation possibility 86

3.7 Fragmentation profitability 87

3.8 Labour re-allocation between Home and Foreign 90

4.1 Manufacturing intra-industry trade: high and increasing intra-industry

trade countries 99

4.2 Increasing returns to scale and perfect and imperfect competition 102

4.3 A trading equilibrium: monopoly versus duopoly 103

4.4 Intra-industry trade as a result of transportation costs 106

xiii List of figures

4.5 The varieties approach of monopolistic competition 110

4.6 Monopolistic competition, demand and costs 112

4.7 Monopolistic competition and foreign trade pressure 115

4A.1 Derivation of firm As reaction curve 122

4A.2 Cournot duopoly equilibrium 123

5.1 Monopolistic competition and the re-location of a firm 137

5.2 Development of world GDP, foreign direct investment (FDI) and trade,

19702000 140

5.3 Profits in the Home and Foreign market: national exporting firm 142

5.4 Going multinational: the horizontal case 143

5.5 Going multinational: the vertical case 144

5.6 Summary of the firms main decisions 145

5.7 The effects of outsourcing on production and income distribution 150

5A.1 Decision process and firm types 154

5A.2 Endowment distributions in the Edgeworth Box 155

5A.3 Characterization of market structure 156

5A.4 Stylized impact of parameter changes for market structure 157

6.1 Global net capital flows, average for fifteen countries 163

6.2 Capital outflows 18601910, selected countries 164

6.3 Net private capital flows to emerging markets, 19922000 166

6.4 Evolution of net financing through international financial markets,

19831998 168

6.5 Evolution of British and American share in foreign assets, 18252000 171

6.6 Interest rate differential, 18801994 175

6.7 Spider web spiral: world imports, JanuaryDecember 19291933 178

6.8 The policy trilemma 183

7.1 Capital mobility is welfare-enhancing 192

7.2 Capital re-allocation between Home and Foreign 199

7.3 Firm investment, supply of funds and asymmetric information 211

8.1 The Asian crisis: rapid drop in the value of some currencies, 19852002 218

8.2 The Asian crisis: current account balance, 19802000 223

8.3 The Asian crisis: developments of GDP per capita, 19902002 225

8.4 Interest rates in Germany and Italy, 19922004 230

8.5 Crises frequency, percentage probability per year 238

9.1 Stylized balance sheets of firms and banks 244

9.2 Financial crisis in an asymmetric information framework 246

9.3 Share of $US-denominated debt, 19961998, selected countries 249

xiv List of figures

9.4 Profitability of non-financial firms, emerging markets, 19922004 251

9.5 Perverse savings and the backward-bending savings curve 255

9.6 The unfolding of a financial crisis 257

9.7 The vicious circle of financial crises 262

10.1 Domestic welfare effects of imposing a tariff 269

10.2 The world welfare effects of a tariff 273

10.3 Predicted duration of the Doha round 278

10.4 Customs union: trade creation 281

10.5 Customs union: trade creation and diversion 282

10.6 The net supply of and demand for funds 287

11.1 France, share of income invested, 1950-2000 310

11.2 Income levels and capital accumulation (Solow) 311

11.3 Education and total factor productivity (TFP) in developing countries 313

11.4 USA: GDP per capita 314

11.5 Japan and Indonesia: GDP per capita 315

11.6 Machinery imports and TFP in developing countries 318

11.7 Intertemporal adjustments in Singapore, 19722001 322

11.8 Foreign research and development (R&D) capital stock and TFP in

developing countries 324

11.9 A Dutch ship in Nagasaki, 1859 327

11.10 The Japanese economy, 15001998 328

11.11 Rapid growth in EuropeAsia trade, 15001800 329

11.12 Multinational trade composition, Portugal, the Netherlands and England 331

11.13 Developments in Chinese income and trade flows, 19602001 333

11.14 China: geographic export market composition, 1997 334

12.1 Results from three experiments: A, B and C 351

12.2 Correlation in cultural characteristics 356

12.3 Correlation between corruption and social economic conditions 364

13.1 Inequality among world citizens, 18201992 378

13.2 Growth rates in open and closed economies, 197089 379

13.3 Income levels, growth rates and population, 19802002 380

14.1 Chinas FDI and trade connections 404

Tables

1.1 The twenty countries with the highest population and population density,

2000 page 8

1.2 Population projections, 20002050, the world and continents 8

1.3 The twenty most powerful economies, 2000 13

1.4 Assumed labour productivity, Australia and Botswana 14

1.5 Price convergence and declining transport cost, 18701913 33

1.6 Tariffs on manufactures for selected countries, 18201950 34

2.1 Analytic presentation: balance of payments, 2002 43

2.2 A firms statement of income 49

2.3 A firms balance sheet 50

2.4 Abstracts from the annual report of DaimlerChrysler, 2003 51

2.5 Abstracts from the annual report of Royal Dutch Shell, 2002 and 2003 52

2.6 Top 100 based on a salesGDP ranking, 2002 57

2.7 Top 100 based on a value addedGDP ranking, 2000 58

2.8 The size ranking of firms in terms of sales vis-a`-vis value added, 2000 59

3.1 Hypothetical labour productivity: production per hour 65

3.2 Production of cloth and wine in the EU and the USA 66

3.3 Sign tests of factor abundance 82

3.4 Multinationals, investment, trade and income 85

4.1 Manufacturing intra-industry trade, 19882000 98

4.2 AirbusBoeing strategic interaction pay-off matrix 109

4.3 Strategic interaction pay-off matrix after Airbus subsidy 109

4.4 Country similarity and intra-industry trade 118

5.1 CIF/FOB ratios, 19651990 127

5.2 Regional trade pattern of Europe, 18601996 128

5.3 Geography of sales 134

5.4 Transport costs 135

5.5 FDI inflows and outflows, share in total flows 141

6.1 Size of net capital flows since 1870, selected countries 163

6.2 Net capital flows to emerging market economies, 19922000 166

xvi List of tables

6.3 Net financing at international financial markets, 19831999, seventeen

countries 169

6.4 Gross financial stocks, 18251938 171

6.5 Looking for the trilemma: estimates of 185

6.6 Effective corporate income tax rates across the EU, 19901999 188

7.1 Correlation between national savings and investment, 19601999 197

7.2 The FeldsteinHorioka test 198

7.3 Institutions and financial development 201

8.1 Real income growth and capital account crises 225

8.2 Median changes in private capital flows and current account 226

8.3 Coordination of a speculative attack 234

8.4 The incidence of global contagion, 19701998 239

9.1 Cost of crises in lost output (relative to trend output) 242

9.2 Developing countries: external debt and equity financing, 19972003 248

9.3 Profitability of non-financial firms in emerging markets, 19922001 250

9.4 Possible relationships between signals and crises 258

9.5 Percentage of crises accurately called 258

9.6 Ratio of short-term debt to total debt and to reserves, June 1997 260

10.1 GATT and WTO rounds, 1947 278

10.2 Gross capital inflow to Chile, 19881997 295

10.3 Annual growth rate, 19701989 302

11.1 GDP per capita, 19902000 growth projections 305

11.2 GDP per capita growth rates per decade, 19602000 306

11.3 GDP per capita 19602000 growth projections 307

11.4 European output and TFP growth, 18702001 316

12.1 Overview of multinational organizations typologies 344

12.2 Top ten non-financial multinationals, 2003, ranked according to TNI 346

12.3 Firm IFirm II interaction pay-off matrix 347

12.4 Reciprocal dumping game 349

12.5 Information, culture and trustworthiness 352

12.6 International cultural diversity in four dimensions, index scores, 1994 355

12.7 Corporate governance around the world 362

12.8 Political risk diversity, 2003 365

12.9 Effectiveness of downsizing 368

12.10 Stock exchange reactions to downsizing announcements 368

12A.1 Firm IFirm II interaction pay-off matrix 371

xvii List of tables

13.1 Price changes, manufacturing industries 384

13.2 Wage differentials, by education 385

13.3 Unemployment and labour skills 386

13.4 Changes in labour productivity, Europe and USA, 19792001 388

13.5 Imported intermediate deliveries, industry, 19741993 389

13.6 Institutions and economic performance 393

Boxes

1.1 Purchasing power parity (PPP) corrections page 14

1.2 Logarithmic graphs 22

2.1 The balance of payments for Germany and the USA 42

2.2 Annual reports for DaimlerChrysler and Royal Dutch Shell 50

2.3 Why accounting is useful and why accounting is not explaining 59

3.1 Wages and productivity 68

3.2 Isoquants 75

3.3 Empirical tests of factor abundance: Ricardo revisited? 81

3.4 Multinationals, fragmentation and investment 85

3.5 The economic effects of international migration 89

3.6 The extent of the firm 92

4.1 Intra-industry trade 97

4.2 Alternative explanations for intra-industry trade 106

4.3 Imperfect competition in international business: Fuji versus Kodak 108

4.4 Models compared 114

4.5 Competitive advantage and MNEs 120

5.1 The relevance of transportation costs 126

5.2 The location decision of MNEs in international business 139

5.3 Another look at multinationals 140

5.4 The regional bias of FDI 147

5.5 Maquiladoras 149

5.6 Competitive advantage and the location decision 151

6.1 The spider web spiral 177

6.2 EU countries and the effective income tax rate 187

7.1 How to test for UIP 194

7.2 The importance of institutions for financial development and growth 203

7.3 Insurance against shocks through portfolio diversification 207

7.4 Ethnic bias in FDI 209

7.5 The financing of firm investment and the external finance premium 214

xix List of boxes

8.1 Foreign exchange risk, hedging and multinational firms 220

8.2 The second-generation model of currency crises 231

9.1 Moral hazard and over-investment: an example 253

10.1 The costs of protection 270

10.2 The EUUSA steel conflict 275

10.3 World Trade Organization (WTO) and General Agreement on Tariffs and Trade

(GATT) trade rounds 277

10.4 The politics of free trade zones: how many trade blocs? 283

10.5 Asset/price inflation 290

10.6 Policy options and moral hazard behaviour 291

10.7 Political risk and the multinational firms investment strategy 296

10.8 Trade, financial liberalization and economic growth 302

11.1 Growth accounting and growth modelling 308

11.2 TFP and school enrolment in developing countries 312

11.3 TFP and imports of machinery and equipment in developing countries 317

11.4 Foreign R&D and TFP in developing countries 324

11.5 VOC: the worlds first multinational 329

11.6 The PrebischSinger hypothesis 336

11.7 A multinationals experience and performance in transition economies 337

12.1 Cross-national culture clashes in the business world 341

12.2 International outsourcing 343

12.3 The case for dominant transnationality 346

12.4 Hard institutions and soft cultures: competition or cooperation? 353

12.5 Culture distance and foreign entry mode 358

12.6 Delegation games and managerial compensation 360

12.7 Institutional diversity 364

12.8 Shareholder value, Americanization and downsizing 367

13.1 Globalization and international labour migration 375

13.2 A closer look at wage differentials and labour market differences 385

13.3 Philips Electronics 387

13.4 Lets dance to the New (International) Order (NIO) 392

14.1 Glocalization 400

14.2 Ceremonial adoption 401

14.3 FDI and trade in China 404

Preface

The title Nations and Firms in the Global Economy: An Introduction to International

Economics and Business reflects our main motivations for writing this book. It con-

tains the six core elements we address (i) introduction, (ii) the global economy,

(iii) nations, (iv) firms, (v) international economics and (vi) international business.

We briefly review these components and their interaction in this preface.

Introduction Our book is an introduction to the subject, indicating that our

target audience consists of students interested in (international) economics and

(international) business for whom this is the first structured encounter with the issues

discussed, who wish to get acquainted with the facts and forces of the hotly debated

globalization process. Depending on the background of the student and the type of

programme (s)he is enrolled in, this first encounter could be in different parts of the

curriculum, although it will usually be in the first or second year of an undergraduate

programme. For other interested readers, this book offers an up-to-date introduction

to what we know about globalization, its drivers and its consequences, particularly

from an economics and business perspective. The preliminary requirements for a

proper understanding of our book are limited. We assume that the reader has taken

an introductory (micro and macro) economics course, and that (s)he has some grasp

of elementary mathematics allowing him or her to understand simple graphs and

equations. We also provide some technical material in boxes, as quick reminders of

essential concepts.

The global economy We analyse the global economyor, as it is more popularly

known: the globalization process. As this is an introduction to the global econ-

omy, we define in chapter 1 what we mean by globalization and what we will and

will not analyze in the sequel. Throughout the book, we provide ample empirical

information on the globalization process so that we may distinguish between fact

and myth. In presenting the facts, we show longer time series than most textbooks

or popular introductions. This enables readers to place current developments into

their proper perspective, providing a better understanding of the developments giv-

ing rise to todays complex structure of the international economy. We address all

the major economic components of the globalization process, both real and mon-

etary. We discuss international trade and capital flows, foreign direct investments

(FDI), multinational firms, exchange rates, financial crises, outsourcing, economic

development, location and much more. In doing so, the emphasis will be more on

xxii Preface

international trade and capital mobility, and less on international labour mobility,

which reflects the fact that in economic terms international trade and capital flows

are much more important than international labour migration, as we shall show.

Nations A proper understanding of the globalization process necessarily looks

at the role of nations, governments and international organizations.

Why do nations specialize in the export of certain types of goods and services, andimport others?

Is specialization always beneficial, or are there winners and losers from the globaliz-ation process?

If so, who are these winners and losers? Why do governments adhere to particular policies regarding exchange rates, trade

flows and capital mobility?

And so on and so forth. We address these and other issues from both a theoretical

and a practical point of view by giving many empirical examples and discussing

numerous case studies.

Firms In many respects, the decisions by individual (multinational) firms pro-

duce the most important driving forces behind the globalization process, ultimately

determining international trade, capital flows and FDI. Naturally, these firms react to

the conditions of the economic environment in which they operate, which is deter-

mined to a considerable extent by governments and international organizations.

Firms therefore both shape the global environment and are shaped by it. Through-

out the book, we discuss the forces with which firms are confronted, the competitive

forces they unleash and how the interaction of these powers influences the firms

organizational structure, human resource management (HRM), corporate gover-

nance and other issues internal to the firm. Here, our focus is on the multinational

enterprise (MNE).

International economics To some extent, it could be argued that the international

economics literature tends to emphasize the role of nations (and comparative advan-

tage) rather than the role of firms in the globalization process. This is, of course, not

entirely accurate as the role of the industrial organization and international business

literatures, and thus the factors influencing the organizational structure of indi-

vidual firms, is becoming increasingly important in the international economics

curriculum. We argue, therefore, that it is becoming increasingly clear that the latter

type of analysis complements the former. Compared to other introductory text-

books on international economics, the primary goal of our book is not to cover the

whole field, but to focus on those theories and insights that help us to understand

the economic causes and consequences of globalization, as well as the role played

by both nations and (multinational) firms. To give just one example, monetary

policy is discussed in our analysis of international capital mobility, but we do not

dwell on issues such as the conduct of monetary policy or the theory of monetary

xxiii Preface

integration as such. We discuss such issues only if they are relevant within the con-

text of the main theme of our book. This also means that when it comes to under-

standing the global economy, we cover a lot more ground than other introductory

textbooks.

International business It could be argued that the international business literature

tends to emphasize the role of firms (and competitive advantage) rather than the

role of nations in the globalization process. This, too, is not entirely accurate as the

international economic environment in which the (multinational) firm operates is

an increasingly important part of the international business curriculum. Once again,

the latter type of analysis complements the former, which is the reason we combine

these perspectives throughout the book. After all, MNEs do not operate in a vacuum

on the contrary, they must take account of all kinds of issues related to international

economics, from exchange rate fluctuations and capital market restrictions to fiscal

policies and labour market conditions.

To complement the material presented in this textbook, there is a website avail-

able providing additional information and supporting material. Its location is:

www.charlesvanmarrewijk.nl.

The website provides: (i) background information on the structure of the book;

(ii) background information on the authors; (iii) additional illustrations and data

material, such as all the figures and tables used in the book; (iv) different types of

exercises for self-study, as well as answers to (a subset of) these exercises; (v) other

self-study material; and (vi) updates, and links to useful other sources of information.

The choice of posting questions on a website rather than including them in the book

itself is motivated by the important advantage that it allows us to integrate and

respond to recent developments in the global economics and business environment

in the questions posed.

Parts of this book were written during a visit by Brakman, Garretsen and van

Marrewijk to the Department of Economics at Princeton University in JuneJuly

2003, and during a visit by van Marrewijk to the School of Economics at the University

of Adelaide in 2004. We are grateful to Princeton University and the University of

Adelaide for their hospitality. In particular, we would like to thank Avinash Dixit,

Gene Grossman and Ian McLean for making these visits possible. Moreover, we are

grateful for financial support from the University of Groningen (Brakman and van

Witteloostuijn), Utrecht School of Economics (Garretsen), the Erasmus University

Trust Fund (van Marrewijk), the University of Adelaide (van Marrewijk) and the

University of Durham (van Witteloostuijn).

We would also like to thank Bart van Ark, Gerrit Faber Karl Farmer, Peter Kenen,

Henryk Kierzkowski and Chris Harrison for help in finding relevant data, and for

providing useful comments and suggestions. Steven Poelhekke provided able research

assistance for parts of this book. Harry Garretsen would also like to thank Hans van

xxiv Preface

Ees, Hans Groeneveld and Ralph de Haas for the opportunity to make use of previous

mutual work.

Steven Brakman

Harry Garretsen

Charles van Marrewijk and

Arjen van WitteloostuijnGroningen, Utrecht, Rotterdam and

GroningenDurham

February 2005

Glossary

ASEAN Association of Southeast Asian Nations

BCG Boston Consulting Group

BIS Bank of International Settlements

boe barrels of oil equivalent

BPR business process re-engineering

CEE Central and Eastern European

CEO chief executive officer

CFO chief financial officer

CIF cost, insurance, freight

CIS Confederation of Independent States

COMESA Common Market of Eastern and Southern Africa

CPE centrally planned economy

FDI foreign direct investment

EADS European Aeronautic Defence and Space Company

EFTA European Free Trade Association

EIC East India Company

EITF Emerging Issues Task Force

EMS European Monetary System

EMU European Monetary Union

EMBI Emerging Market Bond Index

ERM Exchange Rate Mechanism (EU)

EU European Union

EVA economic value added

FOB free on board

FSU former Soviet Union

FTA free trade area

GAAP Generally Accepted Accounting Principles (US)

GATT General Agreement on Tariffs and Trade

GCI gross capital income

GDP gross domestic product

GGDP Groningen Growth and Development Centre

GNP gross national product

HGB German Commercial Code

xxvi Glossary

HRM human resource management

IB international business

ICP International Comparison Project (UN)

ICRG International Country Risk Guide

ICT information and communication technology

IE International economics

IFI international financial institution

IFS International Financial Statistics (IMF)

IMF International Monetary Fund

IO industrial organization

IPO initial public offering

IT information technology

ITC International Trade Commission (US)

JIT just-in-time

JV joint venture

M&As mergers and acquisitions

MC marginal costs

MERCOSUR Southern Common Market

MFN most-favoured-nation

MITI Ministry of International Trade and Industry (Japan)

MNC multinational corporation

MNE multinational enterprise

MPC marginal productivity of capital

MR marginal revenue

NAFTA North American Free Trade Agreement

NIC newly industrializing country

NIO New International Order

NTB non-tariff barrier

NW Net worth

NYSE New York Stock Exchange

OECD Organization for Economic Cooperation and Development

OLI Ownership, Location and Internalization (Dunning)

PPC production possibility curve

PPP purchasing power parity

PTA preferential trade agreement

PWT Penn World Tables

R&D Research and Development

SAR special administrative region (Hong Kong)

SDR Special Drawing Rights (IMF)

SDRM sovereign debt restructuring mechanism

xxvii Glossary

SEC Securities and Exchange Commission (US)

SI savingsinvestment (model)

SITC Standard International Trade Classification

SOE state-owned enterprise

SSA Sub-Saharan Africa

TFP total factor productivity

TNE transnational enterprise

TNI TransNationality Index

UDROP universal debt rollover option with a penalty

UIP uncovered interest parity

UN United Nations

UNHCR United Nations High Commissioner for Refugees

USTR United States Trade Representative

VMPL value marginal product of labour

VOC Verenigde Oostindische Compagnie

WB World Bank

WTO World Trade Organization

Suggested course structure

Our book consists of five parts Introduction (part I), Firms, trade and location

(part II), Capital, currency and crises (part III), Policy, dynamics and organization

(part IV) and Conclusion (part V). As the name suggests, part I provides an intro-

duction into the world economy. We recommend that any course based on this

book should always start with studying chapters 1 and 2. Part II concentrates on

the real aspects of the global economy and analyzes, for example, production struc-

ture, trade flows, multinational firms and migration. Part III concentrates on the

monetary aspects of the global economy and analyzes, for example, exchange rates,

capital flows, investments, risk and uncertainty and financial crises. Depending on

the focus of the course and the available time, either part II or part III can be skipped.

We recommend that any course focusing on the real aspects of the global economy

should study chapters 35 in sequence. Similarly, we recommend that any course

focusing on the monetary aspects of the global economy should study chapters 69

in sequence. The first two chapters of part IV present important topics with a real

monetary combination. Both could be dealt with in a course skipping either part II

or part III of the book, although a more complete comprehension is obtained when

both parts are studied before turning to these chapters. Independently of the details

of the course structure, we always recommend that any course should conclude by

studying chapter 12 (on the organizational implications for the firm of operating in

a global environment) and the two chapters of the concluding part V (an evaluation

of globalization, from both a macro and micro perspective).

Part I

Introduction

1The global economy

KEYWORDS

population GDP in history barriers to trade

distribution of population GDP and GNP GDP per capita

globalization global market integration capital flows

history of globalization migration

1.1 Introduction

Numerous factors active in the global economic environment affect the decisions that

managers of firms have to make regarding the price to charge for their products, how

much to produce, how much to invest in R&D, how much to spend on advertising

and so on. Some of these factors are the number of firms competing in a market,

the relative size of firms, technological and cost considerations, demand conditions

and the ease with which competing foreign firms can enter or exit the market. The

economic globalization process that is, the increased interdependence of national

economies, and the trend towards greater integration of goods, labour and capital

markets (see section 1.4) influences all these factors, and thus indirectly affects

managerial decisions and market organization.

International economics analyses the interactions in the global economic environ-

ment. International business analyses the managerial decisions taken on the basis of

a costbenefit analysis in this global economic environment. In view of the above, we

argue that central topics in international finance, business and public policy cannot

be understood without a knowledge of international economics. Similarly, we con-

clude that the central topics in international economics cannot be fully understood

without insights from international business.

This book provides an introduction to the global economy: what it is, how big

it is, how it functions and how participants interact. Throughout the book, we

analyse how international businesses are affected by the global economic environ-

ment and discuss the role played by firms in this process, thus allowing businesses

to make better decisions. This is our primary perspective. In addition, we discuss

4 Introduction

examples of the other causality: from international businesses to (inter)national

economies.

Before we can begin to analyse the global economy in chapter 2 and beyond,

however, this chapter provides and evaluates some basic theoretical and empirical

background information about the global economy concerning population, income,

international trade, capital flows and the phenomenon of globalization. According to

OECD Secretary-General Donald Johnston (see Maddison, 2001, p. 3), John Maynard

Keynes argued that the master economist should examine the present in light of

the past, for the purposes of the future. We concur with this view, and shall not

only pay attention to the current structure of the global economy, but also discuss

how the economy has evolved over time in particular, how globalization in its

two basic manifestations (international trade and factor mobility) has progressed

and culminated in the two waves of globalization of the nineteenth and twentieth

centuries.

1.2 A sense of time: the universe and population

Some knowledge of the roles of time and history is helpful if we are to appreciate

the modest position of the human species on a cosmic scale, relative to its current

dominant position on our planet, to which we have become so accustomed. It all

started with a Big Bang which created the ever-expanding universe about 13.7 billion

years ago: at least, that is the most recent and accurate estimate of NASAs cosmic

background explorer (COBE) programme, based on measurements of minuscule

differences in temperature. The first stars were formed some 200 million years later

(earlier than initially anticipated). Our galaxy was formed some 10 billion years ago

and our solar system some 5 billion years later. As further summarized in figure 1.1,

the formation of planet earth took some 1.5 billion years, so the geologic eras started

3.5 billion years ago. The atoms gave way to molecules, the molecules to cells and the

cells to life the oldest known fossils (worms and algae) date back 3 billion years.

The process of photosynthesis by plants began some 2 billion years ago. Mankind

appeared on the scene only 1.8 million years ago, taking homo erectus who invented

tools as the starting point. In short, on a cosmic time scale mankind barely exists and

our formidable achievements have not made a lasting impression.

Population size

Estimates of the size of the global population prior to 200 BC are based on archaeolog-

ical and anthropological evidence, see Deevey (1960). In the nomadic period (before

5 The global economy

Big Bang

First stars

Beginning of our galaxy Beginning of our solar system

Beginning of the geologic erasOldest known fossil

Beginning of photosynthesisEnd of precambrian era

End of primary era

present time13.7 billion years

10 billion years

200 million years

200 million years

800 million years

5 billion years3.5 billion years

3 billion years

2 billion years

Figure 1.1 Big Bang and beyond

Data sources: Louis Henri Fournet (1998) and the website http://www.nasa.gov, A baby picture of the

universe tells its age, 11 February 2003.

8000 bc), Fournet (1998, p. 5) notes that: the population subsisted primarily on

gathering berries . . . and . . . it takes about five square kilometres to feed a human

being. Population growth rates were very low for a very long time period. According

to the data sources in Kremer (1993), there were about 125,000 people 1 million years

ago. Their number quadrupled to 1 million in the next 700,000 years and reached

about 170 million when Christ was born. The estimates become more reliable after

this, as they are based on Roman and Chinese censuses.

The developments in world population over the last 2,500 years are illustrated

in figure 1.2. Despite the general upward trend there are periods of stagnation or

decline in world population, for example as a result of the Mongol invasions in the

thirteenth century, the bubonic plague (or Black Death, which wiped out a third

of the European population in the sixth century and again in the fourteenth), the

Thirty Years War (which raged throughout central Europe from 1618 to 1648) and

the collapse of the Ming dynasty in China. A significant increase in the population

growth rate began in the seventeenth century and reached a peak in the 1960s,

leading to dramatic increases in population. There were 1 billion people in 1830,

2 billion in 1930 and more than 6 billion in 2000. The growth in world population is

projected to fall significantly in the twenty-first century, partly as a result of a more

rapid demographic transition process in many developing nations than originally

anticipated and partly as a result of the raging AIDS epidemic, specifically in Africa.

6 Introduction

425265170

6057

0

1000

2000

3000

4000

5000

6000

500 0 500 1000 1500 2000Year

Popu

latio

n (m

illio

n)

Mongol invasions

Black death

30 years war, Ming collapse

Figure 1.2 Development of world population over the last 2,500 years

Data sources: Kremer (1993, table 1) and UN Population Division (2001) (for the estimate of 2000), see

http://www.un.org/popin.data.html.

Nonetheless, since demographic transition processes move as slowly as an oil tanker

in the Thames, the world population is expected by the United Nations (UN) to

increase to about 8.9 billion in 2050 (see figure 1.3).

According to the 2002 revision of the UN population division there were 6 billion

70 million 581 thousand people alive on our planet on 1 July 2000. Of course, given

the inaccuracy of the data, the UN could have been off by a couple of million. Out

of every 100 people alive more than twenty live in China and almost seventeen live

in India. As the only two countries with more than 1 billion inhabitants, China and

India are by far the most populous nations (see table 1.1). The world population is

very unevenly divided, as indicated by the second part of table 1.1. The city-state

of Singapore has the highest population density (6,587 people per km2), followed

by two other small countries (Bermuda and Malta). Only three of the twenty most

populous nations, all located in Asia (Bangladesh, India, and Japan), are also among

the twenty most densely populated nations.

7 The global economy

8,919

0

2,000

4,000

6,000

8,000

10,000

1800 1850 1900 1950 2000 2050year

Popu

latio

n (m

illio

n)High

estimate

Lowestimate

Realization Projection

Figure 1.3 Developments in world population, 20002050, UN projection

Data sources: Kremer (1993, table 1) and UN Population Division (2001), see http://www.un.org/

popin.data.html.

Population projections

In 2000, eleven of the twenty most populous nations were located in Asia, which is

home to almost 3.7 billion people, or about 60 per cent of the world total (table 1.2).

Although the Asian population is expected to increase to 5.4 billion by 2050, its share

is slightly falling to 58 per cent. The population of Africa is expected to increase most

dramatically, from 796 million to 2 billion (from 13 to 22 per cent), while the only

decline is expected in Europe, from 727 to 603 million (or from 12 to 7 per cent).

This can be explained by the much higher total fertility rate the average number

of children per woman in Africa (5.27) than in Europe (1.41). Total fertility is

generally higher in the developing countries than in the developed countries. It is,

for example, below the replacement level of 2.1 children per woman in Europe and

Northern America. Total fertility will decline for all continents except for Europe,

where it will rebound slightly from its current low level.

As a result of better health care systems, sufficient availability of food, and access to

safe water supplies, life expectancy at birth is higher in the developed countries than

in the developing countries (75 years versus 63 years in 2000). This gap will remain

high, although it is expected to narrow over the next fifty years (82 years versus

75 years). Life expectancy is particularly low in Africa (51.4 years), which has been

8 Introduction

Table 1.1 The twenty countries with highest population and population density, 2000

Rank Country Population Country Population density

1 China 1,262 Singapore 6,587

2 India 1,016 Bermuda 1,260

3 USA 282 Malta 1,219

4 Indonesia 210 Bangladesh 1,007

5 Brazil 170 Bahrain 1,001

6 Russian Federation (CIS) 146 Maldives 920

7 Pakistan 138 Barbados 621

8 Bangladesh 131 Mauritius 584

9 Nigeria 127 Aruba 532

10 Japan 127 Korea, Rep. 479

11 Mexico 98 Netherlands 470

12 Germany 82 San Marino 450

13 Vietnam 79 Puerto Rico 442

14 Philippines 76 Lebanon 423

15 Turkey 65 Virgin Islands (US) 356

16 Ethiopia 64 Japan 348

17 Egypt, Arab Rep. 64 Rwanda 345

18 Iran, Islamic Rep. 64 India 342

19 Thailand 61 American Samoa 327

20 UK 60 Belgium 312

Data source: World Bank (2002).

Notes: Population in millions, population density in people per km2.

Table 1.2 Population projections, 20002050, the world and continents

Population Total fertility Life expectancy Median age

2000 2050 2000 2050 2000 2050 2000 2050

World 6,057 9,322 2.82 2.15 65.0 76.0 26.5 36.2

Africa 794 2,000 5.27 2.39 51.4 69.5 18.4 27.4

Asia 3,672 5,428 2.70 2.08 65.8 77.1 26.2 38.3

Latin Americaa 519 806 2.69 2.10 69.3 77.8 24.4 37.8

Europe 727 603 1.41 1.81 73.2 80.8 37.7 49.5

Northern America 314 438 2.00 2.08 76.7 82.7 35.6 41.0

Oceania 31 47 2.41 2.06 73.5 80.6 30.9 38.1

a Unless otherwise specified, the term Latin America includes the Caribbean throughout this

book.

Data source: UN Population Division (2001).

Notes: Population in millions, total fertility in average number of children per woman. Data for

total fertility and life expectancy at birth are five-year estimates (for 19952000 and 204550). The

projections for 2050 are based on the UNs medium variant.

9 The global economy

struck hard by the HIV/AIDS epidemic.1 The most affected countries Botswana,

South Africa, Swaziland and Zimbabwe are all in Africa. The toll of AIDS in terms

of increased mortality and population loss can be devastating. In the thirty-five most

highly affected countries of Africa, for example, life expectancy at birth is estimated

to be 6.5 years less than it would have been in the absence of AIDS, and the population

is projected to be 10 per cent less in 2015 than it would have been without AIDS.

Life expectancy at birth at the world level is estimated to increase from 65 years in

2000 to 76 years in 2050. Although it will probably remain the worlds laggard, the

UN expects a huge increase in African life expectancy (from 51 years in 2000 to

70 years in 2050).

Population ageing will be the major demographic trend for the next fifty years.

The rise in life expectancy at birth combined with the decline in fertility rates

around the world will lead to rapid increases in the share of older people. The median

age the age that divides the population into two equal halves is used as an indicator

of the shift of the population age distribution towards older ages. In 2000 the median

age was 26.5 years, indicating that half of the world population was younger, and

half the world population was older, than 26.5 years. By 2050 the median age will

have increased to 36.2 years. Currently, Africa has the youngest and Europe has the

oldest population (a median age of 18.4 years versus 37.7 years). The most rapid

increases in the median age will occur in Latin America and Europe (the 505050

rule: by 2050 roughly 50 per cent of the European population will be above 50 years

old).

Population and business

Do managers of international firms care about the population distribution, the age

profile, demographic trends and projected developments? Yes, they do. In fact, firms

study such trends closely (and many more trends not discussed above) and try to

predict the implications that these trends are likely to have for their core activities

and strategies. A few examples may illustrate this: First, many automobile firms have started production and assembly plants in China

since 2000, all with the intention of benefiting from the potentially large and rapidly

growing Chinese market: almost 1.3 billion customers! In case you are wondering

why they have not done the same in India, the answer is that automobile firms

have invested only modest amounts there because the Indian income levels (see

p. 13) are too low to generate a substantial demand for cars despite having more

than 1 billion customers.

1 AIDS = acquired immunodeficiency syndrome; HIV = human immunodeficiency virus.

10 Introduction

Second, all major investment firms are increasing the share of their investments in

firms and activities that will benefit from the population ageing process, such as

health care, travel and entertainment and retirement projects. Third, inspired by their marketing departments, firm R&D centres are being given

instructions to find user-friendly solutions for an ageing population, such as milk

cartons that do not spill, bottles and jars that can be opened without using pneu-

matic equipment and digital versatile disc (DVD) players that can be operated

without reading the 150-page instruction book.

Business and population

Businesses are also important drivers of much that happens at the population level,

both nationally and internationally. Clearly, policy-makers are keen to take account of

business developments and try to influence them so that the advantages for society at

large are maximized (or, for that matter, any disadvantages are kept within workable

bounds). Again, a few examples may illustrate this: According to standard economics logic, businesses are the key drivers of macro-

economic performance, such as employment and growth, particularly in capitalist

societies. Within the business world, the production of goods and services is

extensive; many innovations are developed and commercialized. Macroeconomic

developments are thus heavily influenced by microeconomic businesses. The allocation of jobs across the globe, for example, cannot be understood without

insights into the location decision of multinationals. In the late twentieth and early

twenty-first century, much industrial employment moved out of the Western high-

wage region into low-wage developing countries. Many other examples are industry-specific. The pharmaceutical industry, for

instance, is the key producer of new medicines. Because most money is to be

earned in the rich West, the multi-billion R&D efforts of the multinational phar-

maceutical companies are heavily biased toward the invention, development and

commercialization of drugs that can help to prevent or cure Western welfare dis-

eases (e.g. cancer), rather than the much more common Third World plagues (e.g.

malaria).

1.3 Income levels: GNP and GDP

The best indicator of the economic power of a nation is, of course, obtained by

estimating the total value of the goods and services produced in a certain time period.

Actually doing this and comparing the results across nations is a formidable task,

which conceptually requires taking three steps:

11 The global economy

First, a well-functioning statistics office in each nation must gather accurate infor-

mation on the value of millions of goods and services produced and provided

by the firms in the economy. This will be done, of course, in the countrys local

currency that is, dollars in the USA, pounds in the UK, yen in Japan, etc. Second, we have to decide what to compare between nations: gross domestic product

or gross national product. Third, we have to decide how to compare the outcome for the different nations.

Domestic or national product?

As mentioned above, we can either compare GDP or GNP between nations. GDP

is defined as the market value of the goods and services produced by labour and

property located in a country. GNP is defined as the market value of the goods and

services produced by labour and property of residents of a country. If, for example,

a Mexican worker is providing labour services in the USA, these services are part

of American GDP and Mexican GNP. The term located in sometimes needs to be

interpreted broadly for example, if a Filipino sailor is providing labour services for

a Norwegian shipping company, this is part of Norwegian GDP despite the fact that

the ship is not actually located in Norway most of the time. The difference between

GNP and GDP does not hold only for labour services, but also for other factors of

production, such as capital

GDP + Net receipts of factor income = GNP (1.1)

So does it really matter whether we compare countries on the basis of GDP or

GNP? No, for most countries it does not. This is illustrated for 2000 in figure 1.4,

where the GDP and GNP values are measured in current US dollars. Since almost all

observations are very close to a straight 45 line through the origin, the values of GDPand GNP are usually very close to one another. For example, British GDP was $1,415

billion, only 0.2 per cent below its GNP of $1,417 billion. Only two of the thirty-six

countries with an income level above $100 billion have a deviation between GDP and

GNP exceeding 5 per cent, namely Switzerland (where GNP is 5.8 per cent higher

than GDP) and Indonesia (where GNP is 6.9 per cent lower than GDP). For some

of the smaller countries the difference between GDP and GNP can be substantial in

relative terms. For example, capital income from abroad ensures that Kuwaits GNP

is 18.3 per cent higher than its GDP, while payments to capital reduce Irelands

GNP by 14.5 per cent compared to GDP. Unless indicated otherwise, we will use

GDP throughout this book.

12 Introduction

0

500

1000

1500

2000

0 500 1,000 1,500 2,000

GDP

GN

P

Germany

UK

France

Italy

Canada

South Korea

Australia

Figure 1.4 GDP and GNP, current $, 2000

Data source: World Bank (2002).

Note: Data are for 177 countries; observations for Japan and the USA are outside the shown range; the

thin line is a 45 line.

Comparison

When the GDP level for each nation in local currency is simply converted to the

same international standard currency (usually the US dollar, US $) on the basis of

the average exchange rate in the period of observation (the current period), it comes

as no surprise that the USA has the worlds largest economy, with a total production

value of $9.8 trillion (i.e. $9,800 billion) in 2000.2 Since the total value of all goods

and services produced in the world was estimated to be $30.8 trillion, measured this

way the US economy would account for 31.9 per cent of world production, about

double the share of Japan, and five times the share of Germany (see table 1.3). How-

ever, a ranking of the worlds most powerful economies based on production values

measured in current US $ would be deceptive because it would tend to over-estimate

production in the high-income countries relative to the low-income countries. To

understand this, we have to distinguish between tradable and non-tradable goods and

services:

2 Henceforth the $ sign always refers to the US $, unless stated otherwise.

13 The global economy

Table 1.3 The twenty most powerful economies, 2000

GDP ppp GDP GDP per capita

Curr. int. $, billion Current US $ PPP, curr. int. $

Country GDP % of total GDP % of total GDP per capita Rank

1 USA 9,613 21.9 9,837 31.9 34,142 2

2 China 5,019 11.4 1,080 3.5 3,976 90

3 Japan 3,394 7.7 4,842 15.7 26,755 11

4 India 2,395 5.5 457 1.5 2,358 116

5 Germany 2,062 4.7 1,873 6.1 25,103 15

6 France 1,427 3.2 1,294 4.2 24,223 18

7 UK 1,404 3.2 1,415 4.6 23,509 20

8 Italy 1,363 3.1 1,074 3.5 23,626 19

9 Brazil 1,299 3.0 595 1.9 7,625 57

10 Russian Federation (CIS) 1,219 2.8 251 0.8 8,377 55

11 Mexico 884 2.0 575 1.9 9,023 52

12 Canada 856 1.9 688 2.2 27,840 7

13 South Korea 822 1.9 457 1.5 17,380 29

14 Spain 768 1.7 559 1.8 19,472 27

15 Indonesia 640 1.5 153 0.5 3,043 105

16 Australia 493 1.1 390 1.3 25,693 12

17 Argentina 458 1.0 285 0.9 12,377 41

18 Turkey 455 1.0 200 0.6 6,974 63

19 Netherlands 408 0.9 365 1.2 25,657 13

20 South Africa 402 0.9 126 0.4 9,401 48

As the name suggests, tradable goods and services can be transported or provided

in another country, perhaps with some difficulty and at some cost. In principle,

therefore, the providers of tradable goods in different countries compete with one

another fairly directly, implying that the prices of such goods are related and can

be compared effectively on the basis of observed (average) exchange rates. In contrast, non-tradable goods and services have to be provided locally and do

not compete with international providers. Think, for example, of housing services,

getting a haircut, or going to the cinema.

Since (i) different sectors in the same country compete for the same labourers, so

that (ii) the wage rate in an economy reflects the average productivity of a nation

and (iii) productivity differences between nations in the non-tradable sectors tend

to be smaller than in the tradable sectors, converting the value of output in the non-

tradable sectors on the basis of observed exchange rates tends to under-estimate the

value of production in these sectors for the low-income countries, as explained in

box 1.1. For example, on the basis of observed exchange rates, getting a haircut in the

Box 1.1 Purchasing power parity (PPP) corrections

Suppose there are two countries (Australia and Botswana), each producing two

types of goods (traded goods and non-traded goods) using only labour as an input

in the production process. All labourers are equally productive within a country

(homogeneous labour and constant returns to scale), but there are differences

in productivity between countries. As illustrated in table 1.4, we assume Australian

Table 1.4 Assumed labour productivity, Australia and Botswana

Number of products produced per working day

Traded goods Non-traded goods

Australia 20 20

Botswana 4 10

workers to be five times more productive in the traded goods sector and only twice

as productive in the non-traded goods sector: Between-country arbitrage Assuming that there are no transport costs or other

trade restrictions, arbitrage in the traded goods sector will ensure that the wage

rate in Australia will be five times as high as the wage rate in Botswana, because

Australian workers are five times more productive. Taking this as the basis for

international income comparisons leads us to think that per capita income is

400 per cent higher in Australia than it is in Botswana. Within-country arbitrage Assuming labour mobility between sectors within a

country, arbitrage for labour between the traded and non-traded goods sector

will ensure that the price of traded goods in local currency is the same as the

price of non-traded goods in Australia (because labour is equally productive

in the two sectors), whereas the price of traded goods in local currency is 2.5

times as high as the price of non-traded goods in Botswana (because labour

is 2.5 times less productive in the traded goods sector than in the non-traded

goods sector). In local currency, therefore, non-traded goods are much cheaper

compared to traded goods in Botswana than in Australia. Real income comparison Suppose that 40 per cent of income is spent on non-

traded goods in both countries. Some calculations (based on a CobbDouglas

welfare function) then show that the real per capita income is 247 per cent higher

in Australia than in Botswana. Although substantial, this is significantly lower

than our earlier estimate of 400 per cent because non-traded goods are relatively

much cheaper in Botswana than in Australia. The 153 per cent (= 400 247per cent) over-estimated difference between income in current dollars and real

income is larger, (i) the larger the share of income spent on non-traded goods

and (ii) the larger the international deviation between productivity in traded

compared to non-traded goods.

15 The global economy

USA may cost you $10 rather than the $1 you pay in Tanzania, while going to the

cinema in Sweden may cost you $8 rather than the $2 you pay in Jakarta, Indonesia.

In these examples, the value of production in the high-income countries relative to

the low-income countries is over-estimated by a factor of 10 and 4, respectively.

To correct for these differences, the UN International Comparison Project (ICP)

collects data on the prices of goods and services for virtually all countries in the

world and calculates purchasing power parity (PPP) exchange rates, which better

reflect the value of goods and services that can be purchased in a country for a

given amount of dollars (box 1.1). Reporting PPP GDP levels therefore gives a better

estimate of the actual value of production in a country, which is the basis for the

ranking of the most powerful economies in table 1.3. The USA is still the worlds

dominant economy, even though its estimated share of the world total has dropped

from 31.9 per cent to 21.9 per cent. After correcting for purchasing power, China is

the worlds second largest economy (11.4 per cent of the world total), followed by

Japan (7.7 per cent) and India (5.5 per cent). The relative production of China is

more than three times as high after the PPP correction. Similarly for India, Russia

and Indonesia. The reduction in the estimated value of output is particularly large for

Japan (falling from 15.7 per cent to 7.7 per cent), reflecting the high costs of living in

Japan.

Income per capita

For an individual inhabitant of a country, the countrys total production value is

hardly relevant. More important is the production value per person (= per capita). Itshould be noted that income per capita gives an idea of the well-being for the average

person in the country, but gives no information on the distribution of the income

level within the country. If Jack and Jill together earn $100 the average income level

is $50, which holds if they both earn $50 and if Jack earns $1 while Jill earns $99. The

average income level is therefore a poor indicator of the representative situation in

a country if the distribution of income is more skewed. In general, the income level

is more evenly distributed in Europe and Japan than in the USA, where it is in turn

more evenly distributed than in many low-income countries.

Table 1.3 also lists the per capita income levels (corrected for purchasing power)

in 2000 for the most powerful economies. The average income level in the world

was 7,415 current international dollars (CID) per person. The highest income level,

almost seven times the world average, was generated in the tiny country of Luxem-

bourg. The lowest income level ($480 per capita) was measured in Sierra Leone, a

small African nation. High income levels per capita are generated in North America

(the USA and Canada), Australia, Japan, Western Europe, and in some oil producing

nations in the Middle East (e.g. Bahrain, Saudi Arabia, the United Arab Emirates). As

16 Introduction

0

10,000

20,000

30,000

40,000

0 10,000 20,000 30,000 40,000

GDP per capita PPP

GD

P pe

r ca

pita

cur

rent

$

USA

Japan

Russia

Figure 1.5 Correction of GDP per capita for purchasing power, 2000

argued above and illustrated in figure 1.5, the correction generally leads to a down-

ward revision of per capita income for high-income countries such as Japan and to

an upward revision for low-income countries such as Russia. Note, in particular, that

close to the origin in figure 1.5 all observations are clustered significantly below the

45 line.

Income and business

Analogous to the question posed on p. 9 for population distributions and trends,

we may ask: do managers of international firms care about the (dynamic trends

of the) income levels generated in countries, corrections for purchasing power, the

distinction between aggregate and per capita income levels and the distribution of

income? Again, the answer is clear: yes, they do. One of the most crucial questions a

firm asks is: how large will the demand be for this product in a particular region or

country? To answer this question, the total size of the population and the population

density is important, but the total income level and the per capita income level

generated by this population and its distribution across the population is even more

important. Some examples may illustrate this.

In section 1.2 we noted that many automobile firms are investing in China but not

in India, despite the fact that both countries have more than 1 billion inhabitants.

This can be explained by the higher income levels generated in China, where per capita

17 The global economy

income is double that in India measured in current dollars and 70 per cent higher

after correcting for purchasing power, leading to a total income level in China which

is at least double the total income level in India. Together with the more dynamic

developments in China (to be discussed on p. 332) this double income level makes

the Chinese car market much more interesting for automobile companies than the

Indian car market.

To illustrate the importance of per capita income levels for some goods and services

we continue with our ChinaIndia example. Since all human beings require the

consumption of food and drink to survive, everyone spends money on those items,

no matter how low their income level is. Obviously, the higher the income level, the

more you can afford to spend on food and drink and the more luxurious the items

you will buy. Total spending on food and drink will therefore rise quite gradually as

total income level increases. This is not the case, however, for many other goods and

services which people will start to purchase only once their individual income level

has passed a certain threshold level. In the extreme, this holds for the conspicuous

consumption items such as luxury yachts and private jets which only the happy few

can afford.3 A less extreme example is provided by mobile telephones, which people

will buy once their personal income passes a certain level. We noted above that, after

correcting for purchasing power, Chinese per capita income was 70 per cent higher

than Indian per capita income ($3,976 versus $2,358). Apparently, people start to

buy mobile telephones somewhere in between those levels: in 2000 there were 65.8

mobile telephones per 1,000 inhabitants in China, compared to 3.5 in India. The

market for mobile telephones in China is therefore not twice as large as in India

(the total income comparison), but more than 23 times as large (83 million mobile

phones compared to 3.5 million mobile phones).

Business and income

Again, causalities also run the other way around: from business to income. For one

thing, business developments are a key determinant of any countrys GDP per capita.

If a nations businesses prosper, so does GDP per capita. Profitable businesses create

jobs, and profitable businesses can pay well. Loss-making businesses cut jobs, and

additional unemployed put a downward pressure on wages. Without a large and

well-performing business sector, a country will face great difficulty in producing

and sustaining employment and income, as is clear from the economic history of

developing, socialist and former socialist countries that are in the middle of the tran-

sition towards market economies. In an international context, the location decisions

3 The income distribution is important here. Very poor countries may still purchase luxury items if the

income distribution is so skewed that a few very rich people can afford to buy yachts and jets.

18 Introduction

of multinationals influence the cross-country distribution of income, and hence of

GDP per capita. For example, by investing abroad, multinationals stimulate macro-

economic developments in the host countries by creating jobs and paying wages.

Such FDI have a direct impact on the host countries GDP per capita, as well as on

within-country income distribution.

A nice example is the highly publicized development of top salaries in large (multi-

national) enterprises in the late twentieth and the early twenty-first century. Under

the influence of economic and political developments, particularly US large enter-

prises started to pay their top managers extremely well. Economically, the prosperous

1990s produced a tail wind: profit levels skyrocketed, as did share prices. Politically,

the Reaganesque and Thatcherite wave of neo-liberalism, stimulated further by the

collapse of the Soviet communist empire, set the tone for a new Zeitgeist. In many

multinationals across the globe, following the US lead, this was translated into a

shareholders value philosophy. To align the shareholders interests with those of the

managers, managerial remuneration packages became more and more performance-

related by including shares and share options. As a result, with escalating share prices,

the income of many top managers went through the roof. Clearly, this had impli-

cations for the distribution of income, which became more unequal, particularly

because the rise in the employees wages lagged far behind the increase in the top

managers incomes.

1.4 What is the global economy?

The short and uninformative but correct answer to the question what is

globalization? is: everything you want it to be. Many of the heated disputes on

the streets and in the media about the advantages and disadvantages of the global-

ization process arise from the fact that this phrase means different things to different

people. At the 1999 meeting of the WTO in Seattle, the environmentalists dressed in

sea-turtle outfits cared about different issues than the French farm leaders protesting

against the McDonaldization driving out the consumption of Roquefort cheese.

Similarly for the trade unionists and the human right activists. We can consider five

key issues here:4

Cultural globalization This pertains to the debate whether there is a global culture

or a set of universal cultural variables, and the extent to which these displace

embedded national cultures and traditions. The first version of this section was

written in the week in which the fifth Harry Potter book (entitled Harry Potter and

the Order of the Phoenix) went on sale and set new selling records around the globe.

4 See also McDonald and Burton (2002).

19 The global economy

To an unprecedented extent we can have similar cultural experiences in virtually

all countries of the world: we see similar (American) movies, listen to similar

(American and British) music, eat at McDonalds, drink Coca Cola, drive Toyotas,

etc. Often, the carriers of culture globalization are argued to be large multinationals,

which triggered the saying that the world is facing McDonaldization. Some people

are afraid that this will lead to a boring, homogeneous global culture at the expense

of local cultures and traditions. Others are not so gloomy, and see enough room

for local traditions and new developments against a globally oriented background.

After all, there is great regional cultural variety in China even after thousands of

years of common experiences, and similarly for Europe. Be that as it may, cultural

globalization is not the focus of this book. To avoid confusion in this respect from

the start, the title of the book and the title of this section does not use the term

globalization, but global economy. Economic globalization This centres on the decline of national markets and the

rise of global markets as the firms focal point, be it for the production and sale

of final and intermediate goods and services or for the procurement of inputs

(labour and capital). Driven by fundamental changes in technology which permit

new, complicated and more efficient ways of internationally organizing production

processes, the rules of competition are being redefined along the way and firms

and governments will have to learn how to adapt. As suggested by the title of

this book, we focus on the consequences of economic globalization, as defined by

Neary (2003): the increased interdependence of national economies, and the trend

towards greater integration of goods, labour and capital markets. Here, businesses

play a key role, by engaging in FDI and cross-border acquisitions, for example. Geographical globalization This refers to the sensation of compressed time and

space as a result of reduced travel times between locations and the rapid (elec-

tronic) exchange of information. Knowledge and production previously confined

to certain geographical areas may now cross borders and be made available because

of the rapid transfer of information and transport innovations. Some neo-liberals

claim this has led to the end of geography in which location no longer matters

and footloose global capital can quickly cross borders. In a similar vein, global

business players are said to emerge, without any national roots. This develop-

ment is reflected in important cross-border acquisitions and mergers, such as

that of Daimler Benz and Chrysler. Others, notably Porter (1990) and Krugman

(1991), argue that local production processes and their intricate interconnections

are required to gain a competitive advantage. Since the advances in information

technology (IT) and transportation possibilities enable interconnections hitherto

impossible, geography is becoming more, not less, important. Think, for example,

of the clustering of international finance, with three global centres (London, New

York and Tokyo). As this is at the core of many of the economic consequences of

20 Introduction

globalization, it will be discussed and evaluated throughout the remainder of the

book. Institutional globalization This relates to the spread of universal institutional

arrangements across the globe. In the aftermath of US President Reagan and

UK Prime Minister Thatchers influential programme or revolution of

neo-liberalism, in combination with the collapse of communist Soviet-type eco-

nomic systems, more and more countries adopted similar reforms (Albert, 1993).

These reforms share an emphasis on making markets more flexible, privatiz-

ing many former state-owned organizations (SOEs), reducing the size of welfare

arrangements, etc. In an international context, these neo-liberal policies were and

are promoted by such institutions as the International Monetary Fund (IMF) and

the World Bank, which are often said to have forced the Washington Consensus

upon the developing world (Stiglitz, 2002). Another example is the WTO, which

seeks to demolish international barriers to trade, and to the free movement of

factors of production. In a similar vein, micro-level business institutions are influ-

enced by global trends. Multinationals adopt similar policies under the pressure of

competition and regulation. For instance, benchmarking practices are promoted

by global consultancy businesses such as the Boston Consulting Group (BCG)

and McKinsey, and the regulations of the New York Stock Exchange (NYSE) are

imposed upon many non-American enterprises (Sorge and van Witteloostuijn,

2004). As institutions, both at the macro level of countries and at the micro level

of firms, are key determinants of economic processes, we will deal with issues of

institutional globalization throughout the book. Political globalization This refers to the relationship between the power of markets

and (multinational) firms versus the nation-state, which is undergoing continuous

change and updating in reaction to economic and political forces from counter-

cyclical national demand policies and international cooperation after the Second

World War to the renaissance of the belief in the power of the price mechanism

and market forces for efficient allocation of resources in the 1970s. The global-

ization process is conditioned by the (financial) institutions and the dominant

market players, such as multinational corporations (MNCs) and large investment

firms. Some argue that the competitive pressure of international markets will

hollow out the functions of the nation-state and lead to an erosion of sovereignty

and a race-to-the-bottom (be it in corporate tax rates or environmental policies).

Popular anti-globalist rhetoric argues that large multinationals become more and

more powerful, out-powering the majority of nation-states. Others point out that

empirical evidence for these fears is lacking because of the undiminished impor-

tance of the nation-state for providing security, a legal system, education and

infrastructure, all of which are vitally important for attracting the economic activ-

ity required for national prosperity. These issues are also at the core of many of

21 The global economy

the economic consequences of globalization and will therefore be discussed and

evaluated throughout the remainder of this book.

Recall Keynes quote from section 1.1 that the master economist should examine

the present in light of the past, for the purposes of the future. In this respect, it

was argued for quite some time that economic globalization was a totally new phe-

nomenon, so overwhelming in its power that traditional production and organization

patterns would have to succumb to the new realities (Drucker, 1990) and multina-

tional firms would create tight-knit international economic relationships (Ohmae,

1995). Extensive research in the 1990s, however, has shown that economic glob-

alization meaning increased interdependence of national economies and greater

integration of goods, labour and capital markets, is not a new phenomenon in his-

tory at all (see ORourke and Williamson, 1999; Maddison, 2001; Bordo, Taylor and

Williamson, 2003). Before analysing the global economy in section 1.7 and beyond,

we shall therefore first give a brief historical overview of some aspects of the global-

ization process.

1.5 Globalization and income

In his impressive work full of historical detail entitled The World Economy: A Millen-

nial Perspective (2001), Angus Maddison collects detailed statist